Under the judicial economic substance doctrine,
courts disregard an otherwise valid transaction and
its related tax benefits when the transaction serves
no economic purpose other than tax savings. Congress
codified the economic substance doctrine and a related
strict liability penalty under Secs. 7701(o) and
6662(i), respectively, in the Health Care and
Education Reconciliation Act of 2010, P.L. 111-152,
for transactions entered into after March 30, 2010.
This column discusses uncertainty surrounding the
codification of the economic substance doctrine and
explores selected areas of impact on CPAs’
professional obligations and practice. It also
demonstrates that the doctrine must be understood by
all practitioners, not simply those who work with, for
instance, multinational companies.

Introduction to Secs. 7701(o) and 6662(i)

Courts have applied the economic substance doctrine
when there was no meaningful change to the taxpayer’s
economic position other than a purported reduction in
federal income tax, despite technical compliance with
the Code. However, there have been multiple common law
tests for determining economic substance and business
purpose. The Sec. 7701(o) two-prong test creates a
uniform standard.

The test provides that where
the economic substance doctrine is determined to be
relevant, a transaction and its associated tax
benefits will be respected only if (1) the taxpayer’s
economic position changes in a meaningful way and (2)
there is substantial business purpose. “Relevance,”
“meaningful,” and “substantial” are not defined. In
addition, federal, state, and local income tax
benefits cannot be used to demonstrate a change in
economic position or business purpose. The Joint
Committee on Taxation’s (JCT) unofficial report states
that this exclusion does not apply to tax provisions
enacted to induce behavior (e.g., rehabilitation
credits) (JCT, Technical Explanation of
the Revenue Provisions of the “Reconciliation Act of
2010,” as Amended, in Combination with the “Patient
Protection and Affordable Care Act”
(JCX-18-10), p. 152 (March 21, 2010)).

The new
Sec. 6662(b)(6) strict liability penalty applies to
any transaction lacking economic substance under Sec.
7701(o) and “any similar rule of law.” There is no
reasonable cause exception, and the penalty is a
striking 40% if the transaction is undisclosed (Sec.
6662(i)) and 20% if adequately disclosed on Form 8275,
Disclosure Statement, Form 8275-R, Regulation
Disclosure Statement, or Schedule UTP, Uncertain Tax
Position Statement, with additional requirements for
reportable transactions.

“Similar rule of law”
is also ambiguous. For instance, does this include the
substance-over-form and step-transaction doctrines?
The substance-over-form doctrine recharacterizes the
tax treatment to reflect the transaction’s substance.
Similarly, the step-transaction doctrine merges a
series of formally separate steps into a single
transaction and recharacterizes the transaction’s tax
treatment. Conversely, when the Sec. 7701(o) test is
not satisfied, the transaction is disregarded and tax
benefits are disallowed. Despite these differences,
the Sec. 6662(b) penalty may apply.

The IRS
does not intend to provide substantive guidance on the
codified economic substance doctrine (see Notice
2010-62). The JCT provided the following illustrative,
nonexhaustive examples of where it is not
relevant:

(1) the
choice between capitalizing a business enterprise with
debt or equity; (2) a U.S. person’s choice between
utilizing a foreign corporation or a domestic
corporation to make a foreign investment; (3) the
choice to enter a transaction or series of
transactions that constitute a corporate organization
or reorganization under subchapter C; (4) the choice
to utilize a related-party entity in a transaction,
provided that the arm’s length standard . . . [is]
satisfied. [JCT, Technical
Explanation at152–53]

Professional Obligations

Preparer Obligations Under Sec. 6694

Return preparers may be subject to penalties under
Sec. 6694 unless positions on the covered return meet
the relevant authoritative support tests. Although
practitioners may rely in good faith on information
provided by clients in preparing returns, considering
the codified economic substance doctrine in detail in
certain situations likely will be necessary to avoid
Sec. 6694 penalties. For instance, when a transaction
or investment appears tax motivated or depends
significantly on tax benefits to explain the
economics, further economic substance–related inquiry
should be considered. This is critical when evaluating
whether a transaction has a significant purpose of
avoiding or evading federal income tax.

In some
instances, clients may provide internally or
externally prepared advice relating to the doctrine or
a transaction where it is relevant. Practitioners may
rely on this advice after performing adequate due
diligence and determining that the advice is
reasonable. In doing so, the following may be
considered:

The adviser’s competence;

Whether the analysis appears reasonable
on its face;

Whether the adviser was
aware of and considered all the relevant facts and
made reasonable legal conclusions; and

Subsequent legal developments.

The codification of the economic substance doctrine
also affects the Sec. 6694 reasonable cause and
good-faith exceptions. When a transaction is
disregarded under the doctrine, the facts and taxpayer
intentions matter more than technical merits. To
demonstrate reasonable cause and good faith, a
practitioner may have to show a documented
understanding of the transaction. Further, if a
practitioner knew or should have known that the
doctrine was relevant, failing to recommend disclosure
and document consideration of the Sec. 7701(o)
two-prong test may not be considered good faith.

Finally, clients are in the best position to know
of transactions that may lack economic substance.
Practitioners should establish procedures to (1)
inquire into the existence of these transactions, (2)
document responses, and (3) analyze any affirmative
responses to help satisfy their Sec. 6694
obligations.

Circular 230

Codification of the economic substance doctrine
also affects practitioners’ Circular 230 obligations.
First, Circular 230, Section 10.33, is an aspirational
standard that urges the establishment of best
practices when practicing before the IRS. Best
practices include processes that allow the
practitioner to identify relevant facts, appropriately
apply facts to law, and reach proper conclusions. A
better understanding of the facts and how they relate
to the economic substance doctrine should allow
practitioners to appropriately evaluate client
transactions and thus provide quality
representation.

Since the economic substance
doctrine may result in disallowed tax benefits and
significant penalties, evaluating the facts and
circumstances of transactions or matters to which the
doctrine may apply is necessary to satisfy the
Circular 230, Section 10.22, due diligence
obligations. The due diligence process should assist
in identifying when the doctrine may apply and in
discovering relevant facts and motivations, thus
enabling practitioners to estimate risk and exposure
associated with compliance.

These processes
should also help practitioners satisfy their Circular
230, Section 10.34, obligations for positions taken in
tax returns and all other documents submitted to the
IRS on behalf of clients. These standards, effective
August 2, 2011, prohibit practitioners from knowingly
signing a return containing or advising on a position
that:

Lacks a reasonable basis;

Is an unreasonable position under Sec.
6694(a)(2); or

Is a willful attempt to
understate tax liability or a reckless or
intentional disregard of the Sec. 6694(b)(2) rules.

While practitioners may rely in good
faith without verification upon information furnished
by the client, they may not ignore the implications of
incorrect, inconsistent, or incomplete information
provided by the client. Further investigation would be
necessary.

Understanding the facts underlying a
transaction and the taxpayer’s motivations is also
necessary to provide written tax advice under Circular
230, Sections 10.35 and 10.37. Relevant facts must be
uncovered and applied to the applicable law(s) based
on the scope of the advice. Reasonable assumptions of
fact are permitted, but practitioners should not
assume satisfaction of the Sec. 7701(o) two-prong
test, since it is per se
unreasonable under Circular 230 to factually assume
business purpose or a transaction’s potential
profitability apart from its tax benefits.

AICPA SSTS

The Statements on
Standards for Tax Services (SSTS) are enforceable
standards that are part of the AICPA’s professional
standards. The SSTS apply to all tax engagements
undertaken by CPAs, not just federal tax matters.
Although the SSTS create ethical obligations similar
to those discussed above in the Circular 230 and Sec.
6694 subsections, they also provide significant
additional guidance. SSTS No. 1, Tax Return
Positions, paragraph 6 (tax return positions
generally), and No. 7, Form and Content of
Advice to Taxpayers, paragraph 3 (content and
form of advice), contain requirements that
practitioners advise clients on potential penalties
and how to avoid such penalties, if possible, through
disclosure. SSTS No. 3, Certain Procedural
Aspects of Preparing Returns, similar to the
Circular 230 and Sec. 6694 due diligence requirements,
sets a standard of care for potential negligence,
malpractice, or disciplinary actions. Interpretations
1-1 and 1-2 (currently under revision) provide
additional guidance but do not explicitly address the
codification of the economic substance doctrine. CPAs
should carefully consider the economic substance
doctrine in their practice guidelines for tax
compliance and consulting engagements.

Considerations for the Practitioner

Individual Returns

Here, the
economic substance doctrine applies only to
transactions or matters entered into in connection
with a trade or business or an activity engaged in for
the production of income. Thus, individual returns
that contain Schedule C, Profit or Loss from Business,
and Schedule E, Supplemental Income and Loss, are not
exempt from the doctrine, nor is any individual return
that includes items reported on a Schedule K-1. The
economic substance doctrine is generally inapplicable
to individual returns that report primarily salary
income derived solely from W-2s and 1099 investment
income reported on Schedules B and D.

Taxpayers
can use Schedule C to deduct expenses that may not be
“ordinary and necessary” or related to an activity
that has a profit motive. Indeed, this is why the Code
includes so-called hobby loss rules. As such, it has
always been important for practitioners to challenge
clients in this area, but now, with the Sec. 6662(i)
strict liability penalty, it is vital that
practitioners discuss potential economic substance
doctrine penalties with their clients. To the extent
possible, discussions surrounding economic substance
and potentially relevant transactions should occur as
early as possible, perhaps well before tax season
begins in the case of existing clients. Information
surrounding these activities can be reviewed before
receiving final numbers to alleviate some of this
additional burden.

Returns for
Passthrough Entities

Because subchapter K
already has anti-abuse rules, the codification of the
economic substance doctrine may simply present an
additional hurdle. For instance, Regs. Sec. 1.701-2(b)
permits the IRS to recharacterize any passthrough
entity transaction with a principal purpose of
substantially reducing tax liability in a manner
inconsistent with the intent of subchapter K, even if
the transaction is otherwise compliant with tax laws
and regulations. In recharacterizing a transaction,
the regulation provides that statutory and regulatory
principles of law can be considered. This now includes
the codified economic substance doctrine, so
transactions that previously satisfied the anti-abuse
rules may fail under the doctrine.

The IRS may
use the economic substance doctrine to challenge other
partnership transactions, such as the allocation rules
under Sec. 704 and the disguised sale rules under Sec.
707. It is unclear how the doctrine will affect these
matters because the current rules are a mixture of
mechanical rules that are deemed to have a form of
economic substance. Further, consider the treatment of
recourse debt under Sec. 752. A partner can increase
basis by guaranteeing part of a nonrecourse liability
in a manner that poses little economic risk. This
guarantee may fail the Sec. 7701(o) test because the
partner’s economic position has not changed in a
meaningful way (see Cudd, “Recent Tax Law Changes and
Consequences,” in Tax Law Developments
Affecting Private Equity and Venture Capital
(Aspatore 2011)).

These concerns do not exist
in a vacuum and must be considered in the context of
the entire return process. For example, practitioners
should take into account the level of expertise of the
party that is preparing the Schedule K-1. Less
scrutiny can be given to K-1s prepared by specialists
and experienced practitioners. Less deference is
appropriate for and should be given to K-1 preparers
with little or unknown experience. Further, there is
frequently very little time for practitioners to
receive a K-1 and prepare the client’s return. This
crunch adds to the difficulty of satisfying
professional obligations. Practitioners should
consider requesting information on transactions where
the economic substance doctrine may be relevant prior
to receiving the K-1.

Corporate
Returns

Requesting internal and external
prepared tax advice memorandums is a good practice,
especially in the corporate setting, because these
memorandums can be reviewed for high-risk
transactions. For instance, transactions without nexus
to the client’s business are higher risk. Transactions
offsetting large income items (e.g., distressed asset
debt instruments) or involving tax-indifferent parties
are most dubious. While helpful, these steps do not
assist in determining the relevance of the economic
substance doctrine to more common transactions.

Consider the conversion of a corporation’s wholly
owned domestic subsidiary into a limited liability
company (LLC). In the absence of a check-the-box
election, the subsidiary would be viewed as having
liquidated for federal income tax purposes. However,
the liquidation is truly for tax purposes only because
the business continues in the same manner it did
before the election. There is no meaningful change to
the taxpayer’s economic position. This would certainly
fail the Sec. 7701(o) two-prong test; perhaps the
proper conclusion is that the test is not necessary if
it is determined that the doctrine is not relevant to
check-the-box.

There is also the Sec. 338(h)(10)
election where the buyer and seller both treat an
entity sale as an asset sale. The election would
likely fail the Sec. 7701(o) test because the election
is purely tax motivated. Again, perhaps the proper
conclusion is that the doctrine is not relevant.
Finally, there are well-established corporate tax
rules—e.g., the step-transaction and
substance-over-form doctrines—upon which the
application and effect of the doctrine are
unknown.

Prudent Measures to
Consider

A prudent measure would be to broach
the economic substance doctrine with the client during
engagement planning. Initially, clients may need
general background regarding the doctrine, especially
its broad scope, strict liability penalties,
uncertainty, and some examples of when it may
apply.

When contracting for engagements, consider
whether the client should bear sole responsibility for
the codified economic substance doctrine’s strict
liability penalties. The client knows the facts and
circumstance of each transaction. Sec. 6694 and
Circular 230 have due diligence requirements, but
neither imposes a duty to audit. Taking responsibility
for such a penalty is a serious undertaking by the
practitioner. Further, economic substance–related work
may result in additional detail regarding engagement
scope, as well as higher fees because the analysis can
be complicated and time consuming and involve higher
risk.

This is a different and tougher
conversation, however, when a professional has
structured the transaction. More so than in
compliance, clients may believe that economic
substance is the adviser’s responsibility because the
planning and structuring is what the client paid the
adviser to do. Nonetheless, a client should understand
that such advice does not provide Sec. 6662(i) penalty
protection.

Once commencing the engagement, a
practitioner should determine whether the client is
aware of any transactions that may implicate the
doctrine by explaining it in more detail. Inquiries
should focus on nonroutine transactions, with
additional attention given to transactions without
nexus to the client’s business operations and those
proposed by advisers with whom the client does not
have a standing relationship. As always, transactions
that appear to provide significant tax benefits should
be carefully evaluated. When available, practitioners
should obtain copies of opinions, advice, and analysis
provided by external and internal client advisers.
Economic substance–related inquires should be
documented in the practitioner’s working papers. If
the practitioner finds that the economic substance
doctrine is relevant to a particular transaction, the
Sec. 7701(o) two-prong test should be applied to the
transaction, with the results documented and
communicated to the client.

Conclusion

There is significant uncertainty surrounding the
codification of the economic substance doctrine
because no further substantive guidance is expected,
cases interpreting Sec. 7701(o) are years away, and
the precedential value of existing economic substance
doctrine case law is unknown. For now, practitioners
should take a back-to-basics, prudent course. If the
doctrine is potentially applicable to an engagement,
practitioners should discuss the implications with
their clients, consider the issues raised in this
column, and seek additional assistance if
necessary.

EditorNotes

Thomas Purcell III is a professor of accounting and
professor of law at Creighton University in Omaha, NE.
Gregory Fowler is with PricewaterhouseCoopers LLP in
Washington, DC. Andrew Mattson is with Mohler, Nixon
& Williams in Campbell, CA. James Bresnahan II is
with PricewaterhouseCoopers LLP in Washington, DC. Mr.
Fowler is chair and Mr. Purcell and Mr. Mattson are
members of the AICPA’s Tax Practice Responsibilities
Committee.

The winners of The Tax Adviser’s 2016 Best Article Award are Edward Schnee, CPA, Ph.D., and W. Eugene Seago, J.D., Ph.D., for their article, “Taxation of Worthless and Abandoned Partnership Interests.”

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